Saturday, January 22, 2011

Wednesday, January 19, 2011

Muni Bond Market Collapsing?

Teeka Tiwari

If you've been watching the Municipal Bond Market recently, then you know it's been in a free-fall.
Last week, the interest rate on 30-year top rated municipal debt rose above 5 percent for the first time in about two years.
I'll get more into that in a minute, but first a quick primer for the uninitiated ...
Municipal Bonds -- also known as "Munis" or "Muni bonds" -- are debt obligations issued by a city, local government, or agency. The key advantage of Municipal Bonds is that if you are a resident of the state issuing the bond, then the interest that you receive could be triple tax free. This means you would definitely pay no Federal, and potentially pay no State and Local tax, upon the interest that you receive. Because of these tax savings, the yield on a municipal bond is usually lower than that of a taxable bond.
Very often you'll see Munis quoted with two interest rates. The first is the coupon, which is the actual rate of interest paid by the municipality. The second is the taxable equivalent yield.
The taxable equivalent yield assumes that you are in a 28% tax bracket, and it shows you how much interest a taxable bond would have to pay in order to be of an equivalent yield on a triple tax free Muni bond.

Trouble Brewing Ahead
Remember how I said that the rate on Munis is usually lower than the rate on taxable bonds? Well, what's especially troubling right now is that we are seeing rates on Munis actually climb above the rates of taxable bonds!
This is a very clear sign that something is seriously amiss within the municipal market, and that the smart money is beginning to price in some serious doubts about the states' abilities to tap the bond market for fresh cash.
The biggest fundamental funding problem that states and municipalities have is that they have no ability to print their own money. Unlike the Federal government, there are only a finite number of dollars floating around that they can tap into.
So, if they run a budget deficit, they can only bridge that budget gap by either cutting services, defaulting on debt, or raising taxes.
Therefore, I have no doubt that all of us will experience a hiking of sales taxes, state income taxes, and property taxes. Remember: State and local governments have no ability to "extend and pretend" the way the Federal government is doing right now.
The only other way out is if a state economy as a whole experiences a dramatic and prolonged period of strong economic growth. As the businesses and the residents of the state and local municipalities make more money, then of course the tax receipts also increase. But while the U.S. economy is improving, we are nowhere near normalized growth yet, let alone this kind of high growth environment.
But none of these issues are new news. The municipalities that make up each state have been in trouble since the end of 2007 -- so what's spooking the muni market right now?

Under Funded Pension Liabilities!
Besides spending far more than they've been taking in, municipalities all over the country are facing pension shortfalls on the order of 2.5 trillion dollars! To put that number into perspective, you should know that the ENTIRE muni market is 3 trillion dollars!
The problem is that many of these state and local pension funds were accounted for using a projected 8% rate of return. During the 1982 - 2000 bull market, 8% seemed like a breeze. In today's environment, if you can run big money at 8% using strictly investment grade investments, you are heralded as an investing god.
Long story short: Their entire pension funding models and projections are shot. They'll either have to slash and burn services, raise taxes, or default. Illinois has already embraced tax increases by hiking personal income tax from 3% to 5% and bumping up business income tax from 7.3% to 9.5%.
These morons in the Illinois state legislature are killing the goose that lays the golden egg rather than making the hard choices to cut spending. Matt Murphy, a senator from the Chicago suburbs, pithily summed it up when he said, "You think you're stabilizing the budget, but you're not. You're bankrupting our state."
Amen, Matt Murphy!

For those of you looking to trade the volatility that's sure to rock the Municapal bond space, you may want to take a look at the iShares S&P National Municipal Bond Fund, symbol MU